Meaning and Characteristics of Differential Cost

In this article we will discus about the meaning and characteristics of differential cost.

Meaning of Differential Cost:

Differential cost is the change in the costs which may take place due to increase or decrease in output change in sales volume, alternate method of production, make or buy decisions, change in product mix etc. So, differential cost is the result of an alternative course of action.

For example, difference in costs may arise because of replacement of labour by machinery and difference in costs of two alternative courses of action will be the differential cost.

It may be remembered that differential cost may be increase or decrease in costs. Suppose, present cost is Rs.2, 50,000 when the work is done by labour and the expected cost Rs.2, 25,000 when the work is done by machinery.

In this case, differential cost will be decrease in costs Rs.25,000 (i.e., Rs.2,50,000 – Rs.2,25,000) and the decision of replacement of labour by machinery should be implemented by the firm because differential cost of Rs.25,000 (decrease in cost) will increase the profits of the firm by Rs.25,000.

If change in cost occurs due to change in level of activity, differential cost is referred to as incremental cost in case of increase in output and decremental cost in case of decrease in output. However, in practice, no distinction is made between differential cost and incremental or decremental cost and two terms are used to mean the same thing.

Differential costs are often taken as marginal costs or incremental costs. But this is not the case. In differential cost analysis costs are calculated on the basis of absorption or total costing technique, but in marginal costing technique, costs are calculated on the basis of variable costs only and fixed costs are not taken.

But if the alternate course of action does not involve any extra fixed costs change in variable costs will become differential costs and there will be no difference between marginal costs and differential costs.

Differential cost is the change in cost which may result from the adoption of an alternate course of action or change in the level of activity. Change in cost may take place due to change in fixed costs and variable costs, so differential cost is the aggregate of changes in fixed costs and variable costs which take place due to the adoption of an alternate course of action or change in the level of output.

The ascertainment of differential cost becomes easy if a flexible budget is prepared by the concern because it shows cost at various levels of activity.

Characteristics of Differential Costs:

Following are the essential characteristics of differential costs:

a. Differential cost analysis is not made within the accounting records rather it is made outside the accounting records, Differential costs may, however, be incorporated in the flexible budgets because they budget costs at various levels of activity.

b. Total differential costs are considered in differential cost analysis. Cost per unit is not taken into consideration.

c. Total differential revenues are compared with total differential costs before advocating an alternate course of action. A change in course of action is recommended only if differential revenues exceed differential costs.

d. The items of cost which do not change for the alternatives under consideration are ignored, only the difference in items of costs are considered because differential costs analysis is concerned with changes in costs.

e. The changes in costs are measured from a common base point which may be a present course of action or present level of production.

f. Differential cost analysis is related to the future course of action or future level of output, so it deals with future costs. Historical costs or standard costs may be used but they should be suitably adjusted to future conditions.

g. For making a choice among the various alternatives, the alternative which gives the maximum difference between the incremental revenue and incremental cost is recommended to be adopted.